Diagonal Bull Call Spread Explained

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Call Spreads

A call spread is an option spread strategy that is created when equal number of call options are bought and sold simultaneously. Unlike the call buying strategy which have unlimited profit potential, the maximum profit generated by call spreads are limited but they are also, however, comparatively cheaper to implement. Additionally, unlike the outright purchase of call options which can only be employed by bullish investors, call spreads can be constructed to profit from a bull, bear or neutral market.

Vertical Call Spread

One of the most basic spread strategies to implement in options trading is the vertical spread. A vertical call spread is created when the short calls and the long calls have the same expiration date but different strike prices. Vertical call spreads can be bullish or bearish.

Bull Vertical Call Spread

The vertical bull call spread, or simply bull call spread, is used when the option trader thinks that the underlying security’s price will rise before the call options expire.

Bear Vertical Call Spread

The vertical bear call spread, or simply bear call spread, is employed by the option trader who believes that the price of the underlying security will fall before the call options expire.

Calendar (Horizontal) Call Spread

A calendar call spread is created when long term call options are bought and near term call options with the same strike price are sold. Depending on the near term outlook, either the neutral calendar call spread or the bull calendar call spread can be employed.

Neutral Calendar Call Spread

When the option trader’s near term outlook on the underlying is neutral, a neutral calendar call spread can be implemented using at-the-money call options to construct the spread. The main objective of the neutral calendar call spread strategy is to profit from the rapid time decay of the near term options.

Bull Calendar Call Spread

Investors employing the bull calendar call spread are bullish on the underlying on the long term and are selling the near term calls with the intention of riding the long term calls for a discount and sometimes even for free. Out-of-the-money call options are used to construct the bull calendar call spread.

Diagonal Call Spread

A diagonal call spread is created when long term call options are bought and near term call options with a higher strike price are sold. The diagonal call spread is actually very similar to the bull calendar call spread. The main difference is that the near term outlook of the diagonal call spread is slightly more bullish.

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Diagonal Spread w/Calls

NOTE: This graph assumes the strategy was established for a net debit. Also, notice the profit and loss lines are not straight. That’s because the back-month call is still open when the front-month call expires. Straight lines and hard angles usually indicate that all options in the strategy have the same expiration date.

The Strategy

You can think of this as a two-step strategy. It’s a cross between a long calendar spread with calls and a short call spread. It starts out as a time decay play. Then once you sell a second call with strike A (after front-month expiration), you have legged into a short call spread. Ideally, you will be able to establish this strategy for a net credit or for a small net debit. Then, the sale of the second call will be all gravy.

For this Playbook, I’m using the example of one-month diagonal spreads. But please note, it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.

Options Guy’s Tips

Ideally, you want some initial volatility with some predictability. Some volatility is good, because the plan is to sell two options, and you want to get as much as possible for them. On the other hand, we want the stock price to remain relatively stable. That’s a bit of a paradox, and that’s why this strategy is for more advanced traders.

To run this strategy, you need to know how to manage the risk of early assignment on your short options.

The Setup

  • Sell an out-of-the-money call, strike price A (approx. 30 days from expiration – “front-month”)
  • Buy a further out-of-the-money call, strike price B (approx. 60 days from expiration – “back-month”)
  • At expiration of the front-month call, sell another call with strike A and the same expiration as the back-month call
  • Generally, the stock will be below strike A

Who Should Run It

Seasoned Veterans and higher

NOTE: The level of knowledge required for this trade is considerable, because you’re dealing with options that expire on different dates.

When to Run It

You’re expecting neutral activity during the front month, then neutral to bearish activity during the back month.

Break-even at Expiration

It is possible to approximate break-even points, but there are too many variables to give an exact formula.

Because there are two expiration dates for the options in a diagonal spread, a pricing model must be used to “guesstimate” what the value of the back-month call will be when the front-month call expires. Ally Invest’s Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.

The Sweet Spot

For step one, you want the stock price to stay at or around strike A until expiration of the front-month option. For step two, you’ll want the stock price to be below strike A when the back-month option expires.

Maximum Potential Profit

Potential profit is limited to the net credit received for selling both calls with strike A, minus the premium paid for the call with strike B.

NOTE: You can’t precisely calculate potential profit at initiation, because it depends on the premium received for the sale of the second call at a later date.

Maximum Potential Loss

If established for a net credit, risk is limited to the difference between strike A and strike B, minus the net credit received.

If established for a net debit, risk is limited to the difference between strike A and strike B, plus the net debit paid.

NOTE: You can’t precisely calculate your risk at initiation, because it depends on the premium received for the sale of the second call at a later date.

Ally Invest Margin Requirement

Margin requirement is the difference between the strike prices (if the position is closed at expiration of the front-month option).

NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

For this strategy, before front-month expiration, time decay is your friend, since the shorter-term call will lose time value faster than the longer-term call. After closing the front-month call with strike A and selling another call with strike A that has the same expiration as the back-month call with strike B, time decay is somewhat neutral. That’s because you’ll see erosion in the value of both the option you sold (good) and the option you bought (bad).

Implied Volatility

After the strategy is established, although you want neutral movement on the stock if it’s at or below strike A, you’re better off if implied volatility increases close to front-month expiration. That way, you will receive a higher premium for selling another call at strike A.

After front-month expiration, you have legged into a short call spread. So the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.

If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the downside).

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to estimate break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Use the Option Pricing Calculator to “guesstimate” the value of the back-month call you will sell with strike A after closing the front-month call.

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Diagonal Spread

What Is a Diagonal Spread?

A diagonal spread is an options strategy established by simultaneously entering into a long and short position in two options of the same type (two call options or two put options) but with different strike prices and different expiration dates. Typically these structures are on a 1 x 1 ratio.

This strategy can lean bullish or bearish, depending on the structure of the options.

How a Diagonal Spread Works

This strategy is called a diagonal spread because it combines a horizontal spread, also called a time spread or calendar spread, which represents the difference in expiration dates, with a vertical spread, or price spread, which represents the difference in strike prices.

The names horizontal, vertical and diagonal spreads refer to the positions of each option on an options grid. Options are listed in a matrix of strike prices and expiration dates. Therefore, options used in vertical spread strategies are all listed in the same vertical column with the same expiration dates. Options in a horizontal spread strategy use the same strike prices, but are of different expiration dates. The options are therefore arranged horizontally on a calendar.

Options used in diagonal spreads have differing strike prices and expiration days, so the options are arranged diagonally on the quote grid.

Types of Diagonal Spreads

Because there are two factors for each option that are different, namely strike price and expiration date, there are many different types of diagonal spreads. They can be bullish or bearish, long or short and utilize puts or calls.

Most diagonal spreads refer to long spreads and the only requirement is that the holder buys the option with the longer expiration date and sells the option with the shorter expiration date. This is true for call strategies and put strategies alike.

Of course, the converse is also required. Short spreads require that the holder buys the shorter expiration and sells the longer expiration.

What decides whether either a long or short strategy is bullish or bearish is the combination of strike prices. The table below outlines the possibilities:

Diagonal Spreads Diagonal Spreads Expiration Dates Expiration Dates Strike Price Strike Price Underlying Assumption
Calls Long Sell Near Buy Far Buy Lower Sell Higher Bullish
Short Buy Near Sell Far Sell Lower Buy Higher Bearish
Puts Long Sell Near Buy Far Sell Lower Buy Higher Bearish
Short Buy Near Sell Far Buy Lower Sell Higher Bullish

Example of a Diagonal Spread

For example, in a bullish long call diagonal spread, buy the option with the longer expiration date and with a lower strike price and sell the option with the near expiration date and the higher strike price. An example would be to purchase one December $20 call option and the simultaneous sale of one April $25 call.

Logistics

Typically long vertical and long calendar spread results in a debit to the account. With diagonal spreads, the combinations of strikes and expirations will vary, but a long diagonal spread is generally put on for a debit and a short diagonal spread is setup as a credit.

Also, the simplest way to use a diagonal spread is to close the trade when the shorter option expires. However, many traders “roll” the strategy, most often by replacing the expired option with an option with the same strike price but with the expiration of the longer option (or earlier).

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